ETF confusion reigns despite surge in demand

Advisers are looking to increase ETF use, but uncertainty remains around understanding the structure and the potential risks of investing in the vehicles, experts warn.

Over the next year, one in three IFAs in the UK expect clients to increase their exposure to ETFs compared to 4 per cent of IFAs who say exposure will drop, according to a survey from Source ETF.

According to the firm, which interviewed 103 UK advisers, 18 per cent of financial advisers also say their clients have increased their exposure to ETFs over the past year as opposed to 3 per cent who have reduced it.

But experts warn the market crash on August 24 showed that not all passive funds are the same and that investors should be more aware of what a given ETF is invested in.

On the morning of August 24, which has now been termed Black Monday, Chinese markets plummeted, leading many global markets south. Several ETFs saw their net asset values drop as a massive sell-off in the market occurred.

Legal & General Investment Management’s proposition manager for retail index funds Dan Attwood says the falls were more a result of “a huge drying up of liquidity” and less down to the individual securities the funds were tracking.

He says: “When investing in an ETF an investor needs to be aware that there are various layers of liquidity. Firstly, like with index funds, you have to be aware of the liquidity of the underlying securities that the ETF is tracking.”

Attwood says investors need to be aware they will be reliant on market makers in order to manage the liquidity of the products. 

He adds: “If the ETF was tracking US small caps you might expect liquidity to dry up, but the largest falls took place in the large cap US ETFs.

“When the market started falling on hearing the negative news out of China, all the liquidity went to the very largest player in the ETF market, leaving no one left to buy the other shares, and values across the board fell around 20 per cent.”

Vanguard head of UK retail Nick Blake says as ETFs are only a function of the underlying holdings market makers need to make sure they are fairly valuing the ETF based on the underlying securities values.

He says: “ETFs don’t cause volatility they react to it. I think the danger is that people think that ETFs are causing volatility as opposed to what ETFs are actually doing which is responding to it, because they are just a function of what’s actually in the ETF itself.”

Attwood also argues index mutual funds are a more reliable alternative to ETFs as they are not reliant on market makers when it comes to liquidity so their value is not driven by supply and demand.

Lack of knowledge?

Attwood says although ETFs are not as widely accessible as many index funds to a lot of financial advisers, their very low costs will continue to attract investors.

According to Source ETF, 59 per cent of IFAs say that lower charges give ETFs an advantage over other investment funds, followed by 21 per cent who said it was about innovation and 13 per cent who value the variety of ETFs available in the market.      

However, Attwood says the way that ETFs work is “fairly complex” and explaining that to an end client “could be quite difficult”.  

Source ETF’s survey revealed that 14 per cent of IFAs said they do not fully understand ETFs coupled with 34 per cent of them saying that their clients do not fully understand them. 

Combined Financial Strategies director Jonathan McColgan says “very few people” know what an ETF is.

“Only sophisticated clients or people that have been in the industry know what an ETF is. Most clients don’t even know the difference between a unit trust and an open-ended investment companies fund.”

However, Blake says the “familiarity” about ETFs has improved, as well as the appetite and confidence around them.

He says: “Nowadays people understand ETFs. Actually, these are just a different form of Ucits funds, and they’ve got the same protection around them as a natural mutual fund.”

“In the past three years, there have been concerns about synthetic versus physically backed ETFs with people worrying about their structure, however the familiarity about the product has improved,” Blake says.

There are currently more than 1,200 ETFs and ETPs listed on the London Stock Exchange with a total value of £175.7bn, which increased by 61 per cent from a year ago.

Over a half of these assets have been into fixed income ETFs, $1.3bn (£851m) into equity ETFs and $300m into commodity products.